Seller Economies of Scale

March 30, 2024; most recent update April 30, 2024

 

Table of Contents

 

1. Starting Points

2. Introduction

3. Economies of Scale: Essence, Types, and Who it Advantages

    a. Production-Based Economies of Scale

    b. Buying-Based Economies of Scale (Bulk Buying)

    c. Selling-Based Economies of Scale (Bulk Selling)

    d. Bulk Selling as it Usually Conceived

    e. Common Markups: Increasing Profits with Sales

4. Diseconomies of Scale

    a. Cause 1: Added Inefficiencies

    b. Cause 2: Diminishing Returns

    c. Cause 3: Market Saturation

    d. Cause 4: Long-Term Input Shortages

    e. Cause 5: Necessary, Non-Production Investments

    f. Larger Sellers' Double-Edged Sword

5. Mathematically Explaining Some Economies of Scale Concepts

6. Ordinary vs Seller Economies of Scale

    a. Different Immediate Beneficiaries

    b. Different Standards of Success

    c. Different Causation

   

Starting Points

 

For this article, "inventory" means the quantity of items that a producer or middleman has for sale. Depending on the context, it will mean the stock of all items for sale or all items of a specific product for sale (usually the latter, since it's easier to imagine economies of scale that way).

 

A "unit" or "item" of inventory refers not just to individual items that are clearly physically separate from others but also raw, sellable quantities (pound, quart, ton, etc). So, for example, when a business has more raw quantity (e.g. more tonnage) to sell, it also has more units (tons) to sell. Sellable quantities can also be a money amount, such as the coverage of an insurance policy. Thus when someone buys a larger insurance policy, they buy more units from the insurer. In that case, each unit is a dollar, pound, peso, or whatever currency is being used in the transaction.

 

"Necessary revenue" means total business costs plus the business's minimum acceptable profit for a given time period.

 

"Economies of scale" seems like just a plural term, but it also refers to a principle, a concept, a collective phenomenon, and even a goal for some businesses. So it can be written in the singular and usually will be in this article.

 

For simplicity, let's assume a supply chain just of producers, middlemen, and consumers: those who produce goods, those who buy goods from producers  and other middlemen for selling, and those who buy goods from middlemen and producers for consumption.

 

Introduction

 

Economies of scale is an important concept, in understanding the ways that businesses can lower prices for consumers and gain leverage over their competition.

 

The ability to lower prices is by far the biggest implication of economies of scale, for both businesses and consumers. While certainly not the only factor, price is the most important one for consumers generally. Since every buyer has limited money, it's not hard to understand why this is so.

There is a type of economies of scale -- or, rather, economies of scale-like phenomenon -- that exists when a business can offer a lower price per item simply by increasing its inventory through production or buying, or with an increase of items sold in a given transaction. It is not the same as bulk buying or bulk selling; those fall under it. Also, it doesn't start from the perspective of the firm actually reducing its per unit costs but of it being able to reduce the per unit price of its items.

 

So, it's not even a genuine economies of scale. But it's so much like actual economies of scale that it's hard to know what else to call it.

 

Regardless, it's anything but rare or unknown. Whether intentional or not, businesses of tangible goods often or usually achieve this kind of "economies of scale" when they expand since expansion essentially involves an increase in inventory in order to increase profits. Another factory, warehouse, or store; or making an existing factory, warehouse, or store larger; means more space to create and/or store more items. And people will  often speak of prices dropping once a certain company increases product volume, so it's a familiar phenomenon.

 

Yet it's not clear what its name is or if it even has a name. The most accurate name to give it would seem to be "bulk economies of scale." But that's redundant: economies of scale implies bulk. The name would also leave out  the price vantage-point. However, there's another option. All businesses, whether producers or middlemen, have a seller aspect: they sell to buyers, have an inventory, and can offer lower per unit prices simply with a larger inventory. Conceptually, a producer focuses on production costs, while a seller focuses on prices. So, for now, it will be called seller economies of scale. That's not the most impressive name, but there's probably not a better choice.

 

Since this article focuses on seller economies of scale, "economies of scale" will refer to it unless otherwise indicated. Likewise, "diseconomies of scale" will refer to the opposite of seller economies of scale, not the opposite of ordinary economies of scale. "Seller economies of scale" is already pretty long and needs all of the shortening it can get. 

 

Economies of Scale: Essence, Types, and Who it Advantages

 

Economies of scale is the a priori principle that a seller can sell each unit of product at a lower price if the amount of product it [can or does] sell increases disproportionately to any increase in necessary revenue for the same time period. It's also any instance of that principle. The price reduction is possible because the business has more items with which to make a sufficient profit (i.e. the profit it deems necessary for the business to be worthwhile). That gives it the leeway to sell each item at a lower price.

 

Larger, wealthier businesses can usually achieve economies of scale to a greater degree since they are more able to expand their inventory or simply have a larger inventory in the first place, all other factors being equal. This is a main reason why they generally have lower per unit prices than smaller businesses.

 

Essentially there are three types of economies of scale, based on the three kinds of main actions that can result in it: production-based, which pertains solely to producers; buying-based (bulk buying), which pertains solely to middlemen; and seller-based (bulk selling), which can be done either by  producers or middlemen.

 

    Production-Based Economies of Scale

 

Suppose a one-product producer needs a $100-a-month profit for the venture to be worthwhile, can and does make 10 items a month, and it costs $5 each to make (i.e., total business costs divided by the number of units made, per month.) This means the business must charge enough per item to make $150 a month. So, assuming the business will sell all of its monthly production, the necessary minimum price is $15 ($150/10 items). But if production increases to 20 items a month and everything else stays the same, the business needs $200 a month. However, the price per item can then drop to $10 ($200/20 items).

 

Will customers prefer a $15 price or a $10 one? So the ability to produce more is important in increasing product demand and the chances of meeting revenue goals.

 

Notice in the example above, that the production cost per unit didn't fall. No increase in production cost-efficiency is necessary for the producer to lower the price. The increased quantity of product alone takes care of that. A firm with one factory could simply build a second, identical factory with the same number of workers, same kind of machinery, etc. Even though this would raise the firm's production costs, the business could still offer a lower price than before simply if the potential profit from inventory outpaced the increased costs.

 

    Buying-Based Economies of Scale (Bulk Buying)   

 

As mentioned above, economies of scale doesn't just apply to producers but also to middlemen. When a middlemen purchases more from producers or other middlemen than before, they have more inventory to sell to customers, thereby allowing a lower per unit price.

Moreover, even in situations where the production cost of a product increases and the producer must sell the product at a higher per unit price, a middleman can still sell it at the same price they had before or even lower if they buy enough from the producer to compensate or overcompensate for the now-higher price. All that's required is that the producer's new price is still lower than the middleman's original price.

 

Let's say a middleman needs to make a $100 a month profit and they purchase 50 units at $2 each, every month. Therefore they actually need to make $200 a month. So they would need to sell each of the 50 units at a minimum of $4. Now suppose the producer's price rises to $2.50 each due to production cost increases. If the middleman were to again purchase 50 units a month, it would cost them $125 and so they would now have to make $225 with 50 units. Therefore, the necessary price per unit would increase to $4.50 from $4. However, if in those inflationary conditions the middleman were to purchase 100 units a month instead, the purchase would cost $250 and therefore the required monthly revenue would go to $350. But with 100 units to work with, the middleman could achieve $350 at just $3.50 per item.

 

    Selling-Based Economies of Scale (Bulk Selling)   

 

Bulk selling also involves economies of scale but, unlike the other cases, not because the inventory [of a product or as a whole] increases. Instead, a lower per unit price can be offered because there are more units spread across larger purchases than smaller ones.

 

Again, suppose the producer must make $100 a month in profit and each item costs $5 total to make. This puts necessary revenue at $600. They expect they will sell only 50 items, but made 100 for contingency purposes. Expecting only 50 will be sold, they must price each item at $12 ($600/50 items). But if someone requests to purchase all 100, they can each be sold at $6.

 

    Bulk Selling as it is Usually Conceived

 

You might have noticed something odd about the bulk-selling example: why would a business sell a customer 100 items for the same profit as with 50 items sold? Yes, it's conceivable that could happen. Perhaps the seller is just trying to offer a great deal, to ensure that the minimum profit is reached. Since they will obtain the necessary profit needed for the month if the sale happens and have peace of mind, why not? There are other possible reasons a rational seller might do that. But it's not likely to occur. In other words, it's an example of bulk selling based purely on economies of scale, not how bulk selling is normally conceived or usually happens.

 

Economies of scale simply establishes the best per unit price possible for the seller to make the minimum profit needed for a given timeframe. It doesn't mean that a bulk seller will actually set the lowest per unit price according to that minimum profit, nor that the seller will offer their lowest per unit price with any purchase. Usually one of the reasons for offering a lower per unit price is to entice buyers to purchase more of the product so that the seller makes more profit. The buyer has extra incentive to purchase more if the best per unit price is offered only with a larger purchase. This is bulk selling in the way that we usually think of it.

 

Sometimes increasingly better prices are offered over a graduating scale, to entice buyers who can't afford or don't want to make a particularly large purchase.

 

Many factors can determine whether or not a seller sets bulk-selling prices or just a single, constant per unit price for all purchases. If the product is one that the vast majority of buyers will not likely buy more than one of, then the seller might set a constant, low price in order to attract more buyers. If middlemen would have a reason to purchase very large amounts, the seller might give them one extra reason with a bulk-selling price.

 

    Common Markups: Increasing Profits with Sales

 

The examples of economies of scale given have included just the minimum requirements for setting a lower price, not how the price is often or usually set. One of those bare minimums is that the calculation must include the periodic, lowest acceptable profit for the business owner to see the business as worthwhile. And, just as with the bulk-selling example, it's conceiveable that a business might be content with the lowest acceptable profit, perhaps for maximum appeal to customers via the lowest possible price.

 

But with the possibility of increased customer purchases due to more inventory and lower prices, businesses have an incentive to capitalize on that and increase their periodic profits along with their sales. So, rather than reduce the per unit price to what is required under the lowest acceptable profit, businesses are likely to decrease the price less than that and pocket the difference. By doing that with each inventory expansion, the "lowest acceptable profit" increasingly goes beyond what is truly the lowest acceptable profit.

 

Diseconomies of Scale   

 

Diseconomies of scale is the opposite of economies of scale. It is when inventory increases but necessary revenue exceeds the potential revenue from the now-expanded inventory, for a given time period. Or, to use some other common phrases, necessary revenue increases "faster than" or "disproportionate to" the potential revenue from the increased inventory.

All other budgetary factors remaining the same, the per unit price must then be raised.

 

(In contrast, economies of scale means that the potential revenue from the increased inventory exceeds the necessary revenue and therefore a per unit price decrease can happen. More on this, later.)

 

Since "necessary revenue" includes the lowest acceptable profit for a given time period, we can see that diseconomies of scale doesn't necessarily mean that the business would suffer a loss for that period; it could even make a profit. It just means that, at minimum, the lowest acceptable profit cannot be met at the current price.

 

It's helpful to distinguish between extrinsic and intrinsic diseconomies of scale.

 

Extrinsic diseconomies of scale is when costs associated with inventory expansion are insufficient for making necessary revenue exceed the inventory's potential revenue. In this situation, diseconomies of scale happens more or less accidentally, due to budgetary factors outside of the inventory expansion. Natural disasters, lawsuit settlements, and inflation are some examples. These circumstances certainly meet the definition of diseconomies of scale. But they're not beneficial for examining whether or not there are factors in inventory expansion itself that can help cause diseconomies of scale.

 

Intrinsic diseconomies of scale is when inventory-expansion costs are enough for making necessary revenue exceed the inventory's potential revenue. This is a useful concept since, ironically, increasing inventory can often be why a business's necessary revenue exceeds its potential revenue, despite the intent to achieve the opposite. That's especially important since increasing inventory is a key avenue for lowering prices and gaining a more competitive market position, and since it naturally happens as businesses expand in an effort to grow profits and obtain a greater share of the market.

 

This article will focus on intrinsic diseconomies of scale.

 

For producers as producers, it is when the long-term [total cost of increasing production] plus [the lowest acceptable profit] exceed the potential revenue from the increased output. For middlemen, diseconomies of scale isn't due to the cost of merely purchasing the increased merchandise but the long-term investment costs associated with storing and processing it.

 

Causes of intrinsic diseconomies of scale are things that make the sum of [inventory-expansion costs] and the [minimum acceptable profit] surpass the inventory's potential revenue. They are: added inefficiencies; diminishing returns; market saturation; long-term input shortages; and necessary, non-production investments. Added inefficiencies and long-term input shortages are not inevitable, whereas the other three are unavoidable. That's not to say that diseconomies of scale itself is unavoidable. Rather, certain things that make it more likely to happen necessarily occur or would eventually occur, as a business expands its inventory. In contrast (excluding malicious acts), added inefficiencies result from a failure to foresee the negative effects of some change in business production. These are events that may or may not occur and therefore are not inevitable. Likewise, long-term input shortages are arbitrary events that are not destined to happen as a business continues to increase inventory.

 

    Cause 1: Added Inefficiencies   

 

Added inefficiencies apply only to producers. The reason is that middlemen increase inventory essentially by buying, which is a mathematical action. However, inefficiency and efficiency do not apply to mathematics but to the physical and psychological spheres. For example, while there are rules in mathematics that make calculating simpler and quicker, those are valuable mainly for their psychological benefits (more clarity and less mental strain) and less strain on any physical medium a calculation is applied to (a simpler calculation is usually quicker for a computer to process, takes less time and material to write or print, etc). But in math, if a longer route is taken and the procedure and result are correct, it's not mathematically inferior to a shorter path.

 

So when an added inefficiency occurs, it means that a certain task in production becomes physically or mentally harder. More physical or mental resources are required to accomplish it, whether from humans, animals, machines and robots, or inanimate tools. Economically, this means each unit  produced costs more because of increased physical resources or time.

 

Many different situations can involve added inefficiencies. Hiring more workers might increase overall output but cramp factory space, slowing the production per worker. The cutting tools distributed to the new hires may have inferior blades compared to those other employees received, again reducing workers' average production. New machinery might produce items faster than the old, but consume more fuel or have parts that wear down quicker or break more often, significantly increasing energy, maintenance, or replacement costs. Or perhaps the new machinery is not as intuitive as the old, again reducing the long-term productivity per worker. The examples are virtually endless.

 

    Cause 2: Diminishing Returns 

 

But taking measures to avoid added inefficiencies won't prevent a fundamental problem that exists for both producers and middlemen when inventory is expanded: diminishing returns. Despite the name, this is a singular phenomenon that occurs over time; several individual returns, the plural.

 

This isn't the same as economics' diminishing returns involving input and output. This is the diminishing returns of sellers pursuing economies of scale. Mathematically, it becomes increasingly "harder" to reduce a product's price simply by increasing how much of it can be, or is, sold; the seller gets increasingly less of a price decrease (less of a reward) for the same proportion of inventory increase.

 

Sticking with the first example of economies of scale, above, we saw that when the inventory doubled from 10 items to 20, the price fell by a third: from $15 to $10. But at 40 items a month, the price drops to $7.50; at 80 monthly items, $6.25; and so on. The inevitable pattern is this: as inventory doubles, the per unit price reduction shrinks by half.

 

So even if inventory continued to increase by 100%, the eventual price reductions would only be by increasingly smaller fractions of a cent. For all intents and purposes, economies of scale price reductions inevitably flatten.

 

Nevertheless, diminishing returns does not alone cause diseconomies of scale; it never increases the price. However, along with any of the other causes, it can help set the stage for diseconomies of scale. For example, in the early period of inventory increases, price decreases can be significant enough that they mask the real effect of any added inefficiencies that might have occurred during the increase. These added inefficiencies might continue to grow with each inventory expansion. But as diminishing returns continue, the effect of added inefficiencies becomes less insulated and diseconomies of scale is more likely to happen. Thus diminishing returns would help explain why diseconomies of scale happened this time and not during previous inventory increases.

 

Such a scenerio is given below. As you can see, even though the per unit production cost continues to rise for several months -- due to added inefficiencies, let's assume -- the lowest possible price nevertheless keeps dropping until the fifth month, when diseconomies of scale occurs. The reason is that diminishing returns finally prevents the inventory increase from blocking the negative effect of added inefficiencies.

 

[Table 1]

 

                  A        B                C                D                    E

           

                                                                                      Lowest

                              Production  Production    "Acceptable      Possible   

                  Qty      Cost Per      Costs          Profit: $100"    Price

Time Period    Made    Unit          (A * B)        ("C + $100")      (D/A)

-----------    ----    ----          -------        ------------    -----

January.........10........$5.............$50..............$150................$15

February........20........$6.............$120............$220................$11

March...........40.........$7.............$280............$380................$9.50

April.............80.........$8.............$640............$740.................$9.25

May.............160........$9............$1440...........$1540...............$9.63

 

*For simplicity, let's assume production costs cover all of the business's costs and that inventory is its only source of revenue.

 

    Cause 3: Market Saturation

 

Most of the previous examples of economies of scale made sense only if we assumed that the business would sell all of the extra inventory made or bought. While businesses can't know exactly how many units or quantity they will sell, in many cases they can justifiably make a rough prediction and  thus adjust their lowest price or prices accordingly. But what if the estimate is significantly off? What if a good portion of their extra inventory doesn't sell?

 

A business can miss its revenue target for various reasons. But one that always looms in the background with increased business expansion is market saturation. Market saturation is a situation when demand for a product or kind of product has been, or is being, fully satisfied. Therefore, depending on the kind of product, sales of it have been exhausted for the foreseeable future or their average for a given time period (e.g. monthly) is at or past its peak. It can refer to cases when demand has been met in the market as a whole or just for the market in a certain geographical area. For instance, if a business has just local aspirations and demand has been fully met in that area, then for that business the market is saturated.

 

Different things can cause market saturation. For one, certain demographics  might be shrinking or at least not expanding. Also, many products are essentially fads, and only reflect current trends in fashion, taste, and technology. People's wants or needs for them eventually fade. But even for products with a more timeless and universal quality, sales can't increase forever. We enter some very basic, unavoidable facts of the world: there are finite customers and each has finite money.

 

By preventing increased revenue, or preventing it from increasing equally to the costs of increased inventory, market saturation can cause diseconomies of scale. But, like added inefficiencies, it may or may not happen when a business increases its inventory. Still, it's unavoidable in the sense that it would eventually happen if inventory were to continually increase and the chance of it happening necessarily increases as inventory expands.

 

    Cause 4: Long-Term Input Shortages                   

 

In some cases, input shortages can cause diseconomies of scale.

 

Input shortages are shortages of labor, equipment, material, or anything else required for making a certain desired amount of a product or kind of product.

 

In the context of diseconomies of scale, an input shortage is not necessarily a shortage in the market generally. It is a shortage just for any producer wanting to increase inventory beyond what is possible with the inputs available in the market.

 

However, a few conditions must be present for diseconomies of scale to happen.

 

First, by definition, there must be an increase in inventory despite the shortage.

 

Second, the producer must have made production-related investments that,  periodically, cannot be fully paid by the stunted inventory increase. 

 

Third, the investments must have long-term costs -- costs that can't be quickly shed. This also gets back to the definition. For instance, the business might have built one or more factories.

 

Fourth, the input shortage or shortages must be long-term as well.

 

Fifth, the business cannot quickly find alternative inputs or at least not cost-effective ones.

 

    Cause 5: Necessary, Non-Production Investments   

 

So far, the examples of economies of scale have been simplistic in order to clearly show the principle. They would apply in cases where the business, and its increase in inventory or selling, were very small. Let's say you owned a small bakery that made very large, generic cakes that could apply to any occasion: weddings, birthdays, graduations, business celebrations, and so on. If you increased the supply from 10 to 20 cakes a month, you would have to worry about little else but the increased costs for the ingredients, energy, and labor required for making the extra cakes -- at only 20 cakes, the labor might involve you alone. In other words, the increase in total business costs would simply be the increased costs for making more of your product.

 

That would change if your business continued to grow and gather a larger customer base. At first, when sales are low, perhaps you could do it all yourself: make the cakes, answer phone calls, check out customers at the front desk, and so on. But as more people show interest in your product with the lower prices, and you continue to produce more, the increase in answering calls and cashiering would hamper your ability to make the cakes. To continue to increase sales, or even keep them at current levels, would require hiring at least one person to run the register and answer the phone.

 

In other words, eventually non-production workers are needed so that production workers can maximize output and achieve economies of scale. That reflects a more general truth: increasingly there is a need for greater specialization as producers' and middlemen's businesses mature. More kinds of workers will be necessary. More kinds of non-production workers will be required for both; and more kinds of production workers for producers, especially if the producer provides finished goods.

 

That stems from an even more general truth, a simple but profound idea at the heart of the Industrial Revolution and modern economies: usually a person can accomplish more in the same time period by doing one kind of task rather than several (or at least fewer kinds of tasks rather than more). This is because they aren't wasting time (or as much time) going back and forth between different tasks.

 

When your cake shop is in its infancy, you would probably save money by being a DIY generalist or at least hiring a generalist rather than multiple specialists. Demand is low enough that there isn't a great price for occasionally being drawn away from making cakes in order to answer the phone or check out customers. But as business picks up, the cost in lost productivity outweighs the cost of hiring specifically a cashier or a baker so that cake productivity can keep up with demand and revenue can reach its potential. After all, nothing is being accomplished in the periods that a generalist worker runs between the register and the kitchen. So if the number of times workers collectively have to move between different tasks is great, the lost productivity is relatively expensive for the business versus hiring specialists. Both the business and consumers lose: the average wait for customers on the phone or at the register line is longer, cakes are much fewer and prices higher, and profits are likely lower. As the saying goes, "Time is money."

 

If your business continued to grow, it would eventually make sense to further specialize the labor. For example, at some point increased demand would justify separating the bakers into, say, those who deal with the dough and the inside of the cake and those who work on the cake's exterior.

 

Satisfying a growing customer base also eventually demands more locations and/or larger facilities. More space is necessary both to store the increased inventory and to house more workers and equipment needed to either make those goods or get them to the customer. In turn, those usually require more layers of bureaucracy for effective management and oversight. Larger facilities are typically more complex and need managers within certain sections of it, not just general managers. And as a business increases its locations, at some point district management is required in addition to regional management, and so on.

 

So, with inventory expansion, necessary, non-production investments (NNIs) ultimately increase. NNIs are investments needed for business operations but not involved in making more products, unlike production workers, production equipment and machinery, energy, and product materials.

 

However, there are two main problems with NNIs that eventually make diseconomies of scale more likely.

 

First, they add a cost that doesn't also add to production. In that way, any economies of scale advantage that occurred during production is reduced a bit -- or negated in some cases -- when an NNI is added either by a producer or middleman. It's no different than if the producer had taken a costlier route for achieving economies of scale rather than the cheaper route that was chosen: they would have still obtained a lower per unit price than before, but not to the same extent they could have had. Along with diminishing returns, over time this creates a bigger risk of diseconomies of scale.

 

Second is the issue of complexity. NNIs usually get more complex over time and their growing numbers also increase complexity. (So do production-related investments). Both of those lead to additional costs not present at a simpler level. As mentioned above, more or larger business locations or facilities eventually require additional layers of management. But it hardly ends there. Eventually a business needs an accountant, and if it reaches a certain size, an accounting department with different types of accountants. For instance, if the business expands far enough, tax accountants will be needed to ensure tax compliance in different states, counties, cities, and other jurisdictions that might apply. The accounting department will also require management. Much of the blue collar work gets more complicated too. Cleaning, maintenance, and stocking are some examples. In general, they increasingly require greater skills and more sophisticated and expensive equipment as you go from, say, a convenience store or small shop, to a supermarket or medium factory, to a warehouse or large factory. More skilled and specialized labor also tends to be more expensive since it's harder to find.

 

That's far from a complete picture, but at least gives a basic idea of how increased complexity and its associated costs multiply.

 

Clearly, all of these extra costs can unexpectedly creep up on a business, raising it's long-term necessary revenue relative to increased revenue and thus cause diseconomies of scale. These costs are often long-term because, again, they can't be easily cut. Once a large factory or warehouse is built, for example, the right NNI equipment and workforce must remain as well in order to utilize the investment.

 

    Larger Sellers' Double-Edged Sword

 

There are advantages and disadvantages to larger producers' and middlemen's greater ability to expand inventory. Not only does it allow them to achieve economies of scale to a greater degree than their smaller competition, and therefore enjoy price advantages over them. They're also initially more able to weather diminishing returns: because it takes ever-larger amounts of inventory increase to get the same amount of price reduction, they are less likely to suffer the same decreases in price reduction. But that greater capacity to expand also means that they are more likely to reach a greater level of diminishing returns, to reach market saturation, to get the greater complexity and added costs that come with NNIs, and therefore to experience diseconomies of scale.

 

Mathematically Explaining Some Economies of Scale Concepts

 

It can seem magical that something as important as a product's price can be lowered simply by increasing how much of it is in inventory. It can also be vague why economies of scale happens in one case and diseconomies of scale happens in another, or why diminishing returns occurs. So, giving a mathematical explanation for each will help clarify what's going on. 

 

First, what exactly is happening mathematically that causes economies of scale or diseconomies of scale? It's actually simple and not mysterious. It's that [the profit margin per unit] times [the amount of units] either doesn't cover the lowest acceptable profit for the given time period (diseconomies of scale) or more than covers it (economies of scale). And with economies of scale, one more condition is required: that the price can be reduced by the lowest unit of currency -- for this discussion, a penny. Again, it's always mathematically possible to reduce the price by fractions of a cent, but of course that is economically meaningless.

 

Let's revisit Table 1 from the Diminishing Returns section. Production costs were the business's only costs and the lowest acceptable monthly profit was $100. In May, diseconomies of scale occurred when the cost per unit produced rose to $9 and 160 units were made. That's because, with April's per unit price of $9.25, the $0.25 profit margin per unit was too small to meet the $100 profit with 160 units: 160 * $0.25 = $40. Thus the lowest possible price per unit rose from $9.25 to $9.63. But the $9 production cost was below the $9.25 price, so there was still room to lower the price. If, say, 500 units had been produced in May rather than 160 -- and achieving that didn't increase per unit production costs -- then the potential profit would have surpassed the required $100 profit: 500 * $0.25 = $125. Therefore the price could have dropped to $9.20: 500 * $9 = $4500 in production costs, $4500 + $100 = $4600 to get the lowest acceptable profit, and $4600/500 = $9.20 for the lowest possible price.

 

Now, the main question: why is a lower price possible with more units in inventory, all other factors being equal? To rephrase what was said early in the article, it's because there are more units with which to achieve the lowest acceptable profit. Mathematically, that means the lowest acceptable profit is divided by more units for sale, which means a lower price per unit in order to reach that minimum profit.

 

Diminishing returns has a similar explanation. As you divide the minimum profit by an increasingly larger number of units, each unit continues to represent a smaller portion of that minimum profit. But because it represents an increasingly smaller share, that means its price drops by an increasingly smaller amount of the minimum profit. For instance, assume a seller's inventory is given to them, thus no production or purchase costs. With only two units, a minimum profit of $100 requires a $50 price per unit. With four units, $25. With eight, $12.50. And so on. Every time the inventory amount doubles, the portion each unit represents is halved and therefore the price amount each can drop with the next doubling is half of what it could drop this time.

 

Ordinary vs Seller Economies of Scale

 

Finally, we turn to economies of scale as it's usually understood, to compare it with seller economies of scale.

 

Ordinary economies of scale is a situation when increasing the number of units produced, bought, transported, or stored decreases the cost per unit of those actions respectively.

 

For various reasons, definitions of ordinary economies of scale differ. But often they are limited to just production. Economists tend to stick with that kind of definition. At any rate, production provides perhaps the clearest examples of per-unit cost decreases. When ordinary economies of scale is achieved during production, not only does the potential revenue from inventory surpass production costs, but output increases faster than inputs.  For example, suppose 10 workers produce 30 units a day. If the business hires 10 more workers and 80 units are produced a day, then ordinary economies of scale is occurring. The average productivity per worker goes from 3 units daily to 4.

 

What this means is that the production cost per unit decreases. If each worker costs $100 a day, then total labor costs $1000 a day in the first situation. At 30 units a day, that means each unit costs $33.33 in labor ($1000/30 units). In the second situation, total labor costs $2000 a day. But when divided by the 80 units of production, each unit costs $25 in labor.

 

Of course, sellers economies of scale is has nothing to do with per-unit cost  decreases. It's all about per-unit price decreases through increased inventory or larger purchases.

 

In contrast, ordinary economies of scale is all about per-unit cost decreases. It doesn't concern itself with whether or not a per-unit price decrease is possible.

 

Again, it's evident that seller economies of scale is a pseudo economies of scale.

 

    Different Immediate Beneficiaries

 

Because ordinary economies of scale are per-unit costs decreases whereas seller economies of scale are per-unit price decreases, this has implications on who immediately benefits.

 

With ordinary economies of scale the immediate beneficiary is the party increasing the units: the producer reduces its per unit production costs and can then offer a lower price, or the bulk buyer gets an immediate per unit price decrease and, if it is a middleman, can for that reason offer a lower per unit price for its customers.

 

But since the lowest possible price is the focus of sellers economies of scale, the subject is always the business, and the business does not reduce its per unit cost simply by producing or selling more. As for bulk buying, any per unit cost decrease is incidental and due to the policies of the middleman's seller rather than intrinsic to the middleman's simply making a larger purchase. So, even in the unlikely scenario that no seller offers middlemen a lower per unit price for larger purchases, a middleman pursuing seller economies of scale would still go ahead with larger purchases: the goal isn't to lower its per unit costs but the cost per unit for its customers. The business expects or hopes that it will eventually benefit from the lower price through increased sales. But there's no immediate benefit except arbitrarily when sellers offer middlemen per unit savings with larger purchases.

 

The difference in focus is perhaps best seen in cases of bulk selling. In ordinary economies of scale that would be called "bulk buying," since the buyer would get a per unit cost decrease. But in seller economies of scale, it is "bulk selling" since the vantage point is from the seller: being able to offer a lower per unit price for the buyer if they purchase more.

 

The same difference can be seen with the "bulk buying" of seller economies of scale. In ordinary economies of scale, the focus is on middlemen or other buyers (likely) obtaining a per unit cost savings for larger purchases -- that's what bulk buying is, according to it. In seller economies of scale, the focus is on the middleman being able to offer a lower per unit price because of its now-larger inventory from the larger purchases.

 

    Different Standards of Success

 

Because the two economies of scale have different goals, they have different standards of success.

 

Some instances of ordinary economies of scale wouldn't meet the requirements of seller economies of scale. Just because per unit costs are decreasing doesn't mean that potential inventory revenue is increasing faster than necessary revenue: cost increases elsewhere could prevent a per unit price decrease.

 

Likewise, some instances of seller economies of scale wouldn't meet the standards of ordinary economies of scale. In ordinary economies of scale, it's necessary that potential inventory revenue increase faster than production costs. That's an implication of output increasing faster than inputs. But as mentioned before, that's not required for seller economies of scale: the reverse situation could happen, but cost cuts elsewhere could still allow a per unit price decrease.

 

    Different Causation

 

When a business increases its production, a per-unit cost decrease often happens. But when it does, it has nothing to do with simply increasing the inventory. The explanation is not a mathematical one, unlike with seller economies of scale. In ordinary economies of scale, per-unit production costs decrease because of added physical and/or psychological efficiencies: better technology, simpler tasks or instructions for the workers, a simpler product design, more space for workers to perform their job, more cooperation between workers, etc. But these added efficiencies are introduced to increase production as well, which is why it can seem that the higher production is the reason -- or a reason -- behind the per-unit production cost decrease. However, increased production alone will have no effect on per-unit production costs. Other factors must change for the per-unit production cost to fall.

 

Also, it's often assumed that, when inventory increases, the only way price decreases can be happening without eating into profits is that the production cost per unit is dropping. But as we've seen, especially in Table 1, the price can drop even when the per-unit production cost increases. The math behind increased inventory can itself cause a lower price without decreasing profits.

 

So, in brief, added efficiencies can cause both the per unit cost and per unit price to fall, whereas increased inventory alone can cause only the per unit price to drop.

 

Made with Namu6